Your IndustryAug 10 2016

Using platforms to adjust risk and volatility attitude

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Using platforms to adjust risk and volatility attitude

Over the years since the Financial Services Authority carried out its thematic review of consumer risk profiling, there have been some useful developments.

Risk profiling questionnaires are now more reliable (most are statistically tested) and capacity for loss is assessed. However, these are little more than first steps.

Little real progress has been made with the vitally important next step of building investment solutions that match consumers’ risk profiles and deliver on their objectives.

For the most part, all the financial services industry has done is to use a volatility measure as a proxy for risk.

This is very convenient for fund managers because it is easy to measure and relatively easy to control, but as a risk measure, it is not at all relevant to most consumers.

Imagine a curious world in which all a taxi driver needs to know when you get into his or her cab is how fast you want to go.

Well this is very close to where we are as an industry when we produce risk-rated or target risk fund solutions based on volatility and map these to consumer risk profiles.

The most common cause of complaint about an investment is that the outcome has not been what was expected by the consumer

The current risk profiling methodology helps us understand the speed at which the passenger in our “investment vehicle” feels comfortable, but takes no account of where our passenger wishes to go and when he or she hopes to arrive.

The where and when questions are obviously vital and key to understanding the risk of not arriving at the right destination on time.

Just as the passenger in our surreal taxi is unlikely to arrive at the desired destination on time, so too will a consumer invested in a risk-rated or target risk fund, likely to be disappointed with the outcome in terms of meeting his or her objectives.

The most common cause of complaint about an investment is that the outcome has not been what was expected by the consumer. Volatility in the price of an investment might cause concern (even sleepless nights in the extreme), but does not lead to loss or failure to meet an objective unless the concern leads the consumer to bail out at the wrong moment.

By focusing on volatility the industry has chosen to focus on a convenient but, largely, irrelevant measure of risk. Consumers’ concerns are generally focused on outcomes, and volatility is a very poor proxy for a real-world outcome.

Indeed, part of the adviser’s job is to help consumers understand that markets are volatile and the importance of holding their nerve in order to achieve long-term objectives.

Just as speed is not a risk – the risk is of a car crash, so neither is volatility. The real risks that consumers face are:

• Capital loss on early disinvestment;

• Failure to meet a desired investment objective, for example repaying a mortgage by a desired date;

• Loss of purchasing power due to inflation;

• Failure to achieve a retirement objective: income level or targeted retirement date;

• Capital depletion by drawing a level of income that cannot be supported;

• Lack of liquidity when there is a need to disinvest;

• Failure of the investment provider or counterparty;

• Lack of diversification, that is, an over-concentration in particular products or funds;

• Under-performance due to overly conservative investment choices.

It follows that the score from a psychometric risk questionnaire does not say anything about which of the above risks most concerns the consumer, or anything directly about his or her personal circumstances.

The key to understanding risk is to understand the reason for investment. Consumers frequently have no real notion of investment risk.

But they are generally clear in their wish not to lose their money. And, perhaps with some help, they can articulate important objectives, such as wanting to have enough for a decent retirement to pay off the mortgage or to fund the education of their children or grandchildren.

Once consumers have stated their objectives, the risks become clear. For example, for a long-term capital accumulation goal, the risk is capital loss on early disinvestment or capital erosion due to inflation.

Key points

The most common cause of complaint about an investment is that the outcome has not been what was expected by the consumer.

The key to understanding risk is to understand the reason for investment.

A risk profile based on a volatility measure communicates nothing about the risks consumers really care about.

Many of the compensation claims made by consumers arise because their expectations were not set realistically at outset. A risk profile based on a volatility measure communicates nothing about the risks consumers really care about, for example, not being able to repay a mortgage or retire with an adequate income when they want to.

The ability of disappointed and angry consumers to effectively define risk retrospectively, when their objectives are not met, arises directly as a result of a failure to articulate clearly investment objectives at the outset and understand the risks that might result in not achieving them.

Much of the comment on robo advice, as it is unfortunately called, focuses on its limited scope and ability to help close the mass market advice gap.

It might at first sight seem unlikely that it can help the industry do a better job at communicating risk and matching it with appropriate investment solutions. However, although robo advice can never compete with traditionally delivered advice from an experienced professional, two features that, paradoxically, stem from its limitations, point the way ahead.

The first is that robo advice must be focused on a particular need are, and therefore the objective of the investment is, by definition, clear. For retirement planning, the risks are that:

• The desired level of income will not be achieved;

• Retirement may need to be delayed;

• Inflation may erode the planned retirement income.

Because robo advice offers no (or very limited) contact with human advisers, the second feature is that much greater effort has to be made to set consumer expectations carefully. In a well-designed robo process, stochastic forecasts of the outcomes are given prominence.

Consumers can change the amounts invested, the timescale and even the objective target amount to achieve optimal outcomes for themselves. The risks of failure can be clearly seen and realistic objectives can be set in the light of these risks.

If volatility of markets is mentioned, it is there to inform consumers, but does not drive recommended solutions.

Certainly, not all robo advice systems are wonderful, and there are obvious limitations compared to traditionally delivered advice.

However, because of these limitations, extra effort has to be applied using technology to translate the results from a risk profile questionnaire into something meaningful to consumers – namely the risk of not being able to fulfil their goals.

The technology behind robo advice can be applied generally to support traditional advice, and offers something far superior and much more defensible than simply mapping the output from a risk questionnaire to investment solutions based on volatility alone.

Bruce Moss is strategy director of eValue